ssrn-id94034

Separation of Ownership and Control

Eugene F. Fama University of Chicago

[email protected]

and

Michael C. Jensen Harvard Business School

[email protected]

Abstract

This paper analyzes the survival of organizations in which decision agents do not bear a major share of the wealth effects of their decisions. This is what the literature on large corporations calls separation of ownership and control. Such separation of decision and risk bearing functions is also common to organizations like large professional partnerships, financial mutuals and nonprofits. We contend that separation of decision and risk bearing functions survives in these organizations in part because of the benefits of specialization of management and risk bearing but also because of an effective common approach to controlling the implied agency problems. In particular, the contract structures of all these organizations separate the ratification and monitoring of decisions from the initiation and implementation of the decisions.

Copyright 1983. Eugene F. Fama and Michael C. Jensen. All rights reserved.

Journal of Law and Economics, Vol. XXVI, June 1983.

Also published in

Foundations of Organizational Strategy, Michael C. Jensen, Harvard University Press, 1998.

You may redistribute this document freely, but please do not post the electronic file on the web. I welcome

web links to this document at http://papers.ssrn.com/abstract=94034. I revise my papers regularly, and providing a link to the original ensures that readers will receive the most recent version.

Thank you, Michael C. Jensen

* This paper is a revision of parts of our earlier paper, The Survival of Organizations (September 1980). In the course of this work we have profited from the comments of R. Antle, R. Benne, F. Black, F. Easterbrook, A. Farber, W. Gavett, P. Hirsch, R. Hogarth, C. Holderness, R. Holthausen, C. Horne, J. Jeuck, R. Leftwich, S. McCormick, D. Mayers, P. Pashigian, M. Scholes, C. Smith, G. Stigler, R. Watts, T. Whisler, R. Yeaple, J. Zimmerman, and especially A. Alchian, W. Meckling, and C. Plosser. Financial support for Famas participation is from the National Science Foundation. Jensen is supported by the Managerial Economics Research Center of the University of Rochester.

Separation of Ownership and Control*

Eugene F. Fama and Michael C. Jensen

Journal of Law and Economics, Vol. XXVI, June 1983. Foundations of Organizational Strategy, Michael C. Jensen, Harvard University Press, 1998.

I. Introduction

Absent fiat, the form of organization that survives in an activity is the one that

delivers the product demanded by customers at the lowest price while covering costs.1

Our goal is to explain the survival of organizations characterized by separation of

ownership and controla problem that has bothered students of corporations from

Adam Smith to Berle and Means and Jensen and Meckling.2 In more precise language,

we are concerned with the survival of organizations in which important decision agents

do not bear a substantial share of the wealth effects of their decisions.

We argue that the separation of decision and risk-bearing functions observed in

large corporations is common to other organizations such as large professional

partnerships, financial mutuals, and nonprofits. We contend that separation of decision

and risk-bearing functions survives in these organizations in part because of the benefits

1 Alchian (1950) is an early proponent of the use of natural selection in economic analysis. For a survey of general issues in the analysis of organization, see Jensen (1983).

2 Smith (1776); Berle and Means (1932); and Jensen and Meckling (1976).

Fama and Jensen 1983 2

of specialization of management and risk bearing but also because of an effective

common approach to controlling the agency problems caused by separation of decision

and risk-bearing functions. In particular, our hypothesis is that the contract structures of

all of these organizations separate the ratification and monitoring of decisions from

initiation and implementation of the decisions.

II. Residual Claims and Decision Processes

An organization is the nexus of contracts, written and unwritten, among owners of

factors of production and customers.3 These contracts or internal rules of the game

specify the rights of each agent in the organization, performance criteria on which agents

are evaluated, and the payoff functions they face. The contract structure combines with

available production technologies and external legal constraints to determine the cost

function for delivering an output with a particular form of organization.4 The form of

organization that delivers the output demanded by customers at the lowest price, while

covering costs, survives.

The central contracts in any organization specify (1) the nature of residual claims

and (2) the allocation of the steps of the decision process among agents. These contracts

distinguish organizations from one another and explain why specific organizational forms

survive. We first discuss the general characteristics of residual claims and decision

processes. We then present the major hypotheses about the relations between efficient

allocations of residual claims and decision functions. The analysis focuses on two broad

types of organizationsthose in which risk-bearing and decision functions are separated

and those in which they are combined in the same agents. We analyze only private

organizations that depend on voluntary contracting and exchange.

3 See Jensen and Meckling (1976).

4 See Jensen and Meckling (1979).


A. Residual Claims

The contract structures of most organizational forms limit the risks undertaken by

most agents by specifying either fixed promised payoffs or incentive payoffs tied to

specific measures of performance. The residual riskthe risk of the difference between

stochastic inflows of resources and promised payments to agentsis borne by those who

contract for the rights to net cash flows. We call these agents the residual claimants or

residual risk bearers. Moreover, the contracts of most agents contain the implicit or

explicit provision that, in exchange for the specified payoff, the agent agrees that the

resources he provides can be used to satisfy the interests of residual claimants.

Having most uncertainty borne by one group of agents, residual claimants, has

survival value because it reduces the costs incurred to monitor contracts with other

groups of agents and to adjust contracts for the changing risks borne by other agents.

Contracts that direct decisions toward the interests of residual claimants also add to the

survival value of organizations. Producing outputs at lower cost is in the interests of

residual claimants because it increases net cash flows, but lower costs also contribute to

survival by allowing products to be delivered at lower prices.

The residual claims of different organizational forms contain different restrictions.

For example, the least restricted residual claims in common use are the common stocks of

large corporations. Stockholders are not required to have any other role in the

organization; their residual claims are alienable without restriction; and, because of these

provisions, the residual claims allow unrestricted risk sharing among stockholders. We

call these organizations open corporations to distinguish them from closed corporations

that are generally smaller and have residual claims that are largely restricted to internal

decision agents.5

5 The terms public corporation and close corporation, which are common in the legal literature, are not used here. Closed corporation seems more descriptive than close corporation. The term public


B. The Decision Process

By focusing on entrepreneurial firms in which all decision rights are concentrated

in the entrepreneur, economists tend to ignore analysis of the steps of the decision

process. However, the way organizations allocate the steps of the decision process across

agents is important in explaining the survival of organizations.

In broad terms, the decision process has four steps:

initiationgeneration of proposals for resource utilization and structuring of

contracts;

ratificationchoice of the decision initiatives to be implemented;

implementationexecution of ratified decisions; and

monitoringmeasurement of the performance of decision agents and

implementation of rewards.

Because the initiation and implementation of decisions typically are allocated to

the same agents, it is convenient to combine these two functions under the term decision

management. Likewise, the term decision control includes the ratification and monitoring

of decisions. Decision management and decision control are the components of the

organizations decision process or decision system.

III. Fundamental Relations Between Risk-Bearing and Decision Processes

We first state and then elaborate the central complementary hypotheses about the

relations between the risk-bearing and decision processes of organizations.

Separation of residual risk bearing from decision management leads to decision

systems that separate decision management from decision control.

Combination of decision management and decision control in a few agents leads

to residual claims that are largely restricted to these agents.

corporation best describes government-owned corporations such as Amtrak and the TVA. In contrast, what we call open corporations are private organizations.


A. The Problem

Agency problems arise because contracts are not costlessly written and enforced.

Agency costs include the costs of structuring, monitoring, and bonding a set of contracts

among agents with conflicting interests. Agency costs also include the value of output

lost because the costs of full enforcement of contracts exceed the benefits.6

Control of agency problems in the decision process is important when the

decision managers who initiate and implement important decisions are not the major

residual claimants and therefore do not bear a major share of the wealth effects of their

decisions. Without effective control procedures, such decision managers are more likely

to take actions that deviate from the interests of residual claimants. An effective system

for decision control implies, almost by definition, that the control (ratification and

monitoring) of decisions is to some extent separate from the management (initiation and

implementation) of decisions. Individual decision agents can be involved in the

management of some decisions and the control of others, but separation means that an

individual agent does not exercise exclusive management and control rights over the

same decisions.

The interesting problem is to determine when separation of decision management,

decision control, and residual risk bearing is more efficient than combining these three

functions in the same agents. We first analyze the factors that make combination of

decision management, decision control, and residual risk bearing efficient. We then

analyze the factors that make separation of these three functions efficient.

B. Combination of Decision Management, Decision Control, and Residual Risk Bearing

Suppose the balance of cost conditions, including both technology and the control

of agency problems, implies that in a particular activity the optimal organization is

6 This definition of agency costs comes from Jensen and Meckling (1976).


noncomplex. For our purposes, noncomplex means that specific information relevant to

decisions is concentrated in one or a few agents. (Specific information is detailed

information that is costly to transfer among agents.)7 Most small organizations tend to be

noncomplex, and most large organizations tend to be complex, but the correspondence is

not perfect. For example, research oriented universities, though often small in terms of

assets or faculty size, are nevertheless complex in the sense that specific knowledge,

which is costly to transfer, is diffused among both faculty and administrators. On the

other hand, mutual funds are often large in terms of assets but noncomplex in the sense

that information relevant to decisions is concentrated in one or a few agents. We take it as

given that optimal organizations in some activities are noncomplex. Our more limited

goal is to explain the implications of noncomplexity for control of agency problems in the

decision process.

If we ignore agency problems between decision managers and residual claimants,

the theory of optimal risk bearing tells us that residual claims that allow unrestricted risk

sharing have advantages in small as well as in large organizations.8 However, in a small

noncomplex organization, specific knowledge important for decision management and

control is concentrated in one or a few agents. As a consequence, it is efficient to allocate

decision control as well as decision management to these agents. Without separation of

decision management from decision control, residual claimants have little protection

against opportunistic actions of decision agents, and this lowers the value of unrestricted

residual claims.

7 Specific information is closely related to the notions of information impactedness and bounded rationality discussed in Williamson (1975) and (1981). Hayek (1945) uses specific information to discuss the role of markets in complex economies. See also Sowell (1980). Our analysis of the relations between specific information and efficient decision processes owes much to ongoing work with William Meckling.

8 See, for example, Arrow (1964); or Fama (1976, chs. 6 & 7).


A feasible solution to the agency problem that arises when the same agents

manage and control important decisions is to restrict residual claims to the important

decision agents. In effect, restriction of residual claims to decision agents substitutes for

costly control devices to limit the discretion of decision agents. The common stocks of

closed corporations are this type of restricted residual claim, as are the residual claims in

proprietorships and partnerships. The residual claims of these organizations (especially

closed corporations) are also held by other agents whose special relations with decision

agents allow agency problems to be controlled without separation of the management and

control of decisions. For example, family members have many dimensions of exchange

with one another over a long horizon and therefore have advantages in monitoring and

disciplining related decision agents. Business associates whose goodwill and advice are

important to the organization are also potential candidates for holding minority residual

claims of organizations that do not separate the management and control of decisions.9

Restricting residual claims to decision makers controls agency problems between

residual claimants and decision agents, but it sacrifices the benefits of unrestricted risk

sharing and specialization of decision functions. The decision process suffers efficiency

losses because decision agents must be chosen on the basis of wealth and willingness to

bear risk as well as for decision skills. The residual claimants forgo optimal risk

reduction through portfolio diversification so that residual claims and decision making

can be combined in a small number of agents. Forgone diversification lowers the value of

the residual claims and raises the cost of risk-bearing services.

Moreover, when residual claims are restricted to decision agents, it is generally

rational for the residual claimantdecision makers to assign lower values to uncertain

9 In contrast, the analysis predicts that when venture equity capital is put into a small entrepreneurial organization by outsiders, mechanisms for separating the management and control of important decisions are instituted.


cash flows than residual claimants would in organizations where residual claims are

unrestricted and risk bearing can be freely diversified across organizations. As a

consequence, restricting residual claims to agents in the decision process leads to

decisions (for example, less investment in risky projects that lower the costs of outputs)

that tend to penalize the organization in the competition for survival.10

However, because contracts are not costlessly written and enforced, all decision

systems and systems for allocating residual claims involve costs. Organizational survival

involves a balance of the costs of alternative decision systems and systems for allocating

residual risk against the benefits. Small noncomplex organizations do not have demands

for a wide range of specialized decision agents; on the contrary, concentration of specific

information relevant to decisions implies that there are efficiency gains when the rights to

manage and control decisions are combined in one or a few agents. Moreover, the risk-

sharing benefits forgone when residual claims are restricted to one or a few decision

agents are less serious in a small noncomplex organization than in a large organization,

because the total risk of net cash flows to be shared is generally smaller in small

organizations. In addition, small organizations do not often have large demands for

wealth from residual claimants to bond the payoffs promised to other agents and to

purchase risky assets. As a consequence, small noncomplex organizations can efficiently

control the agency problems caused by the combination of decision management and

control in one or a few agents by restricting residual claims to these agents. Such a

combining of decision and risk-bearing functions is efficient in small noncomplex

organizations because the benefits of unrestricted risk sharing and specialization of

decision functions are less than the costs that would be incurred to control the resulting

agency problems.

10 These propositions are developed in. Fama and Jensen (1983).


The proprietorships, partnerships, and closed corporations observed in small scale

production and service activities are the best examples of classical entrepreneurial firms

in which the major decision makers are also the major residual risk bearers. These

organizations are evidence in favor of the hypothesis that combination of decision

management and decision control in one or a few agents leads to residual claims that are

largely restricted to these agents.

We analyze next the forces that make separation of decision management,

decision control, and residual risk bearing efficientin effect, the forces that cause the

classical entrepreneurial firm to be dominated by organizational forms in which there are

no decision makers in the classical entrepreneurial sense.

C. Separation of Decision Management, Decision Control, and Residual Risk Bearing

Our concern in this section is with the organizational forms characterized by

separation of decision management from residual risk bearingwhat the literature on

open corporations calls, somewhat imprecisely, separation of ownership and control. Our

hypothesis is that all such organizations, including large open corporations, large

professional partnerships, financial mutuals, and nonprofits, control the agency problems

that result from separation of decision management from residual risk bearing by

separating the management (initiation and implementation) and control (ratification and

monitoring) of decisions. Documentation of this hypothesis takes up much of the rest of

the paper.

1. Specific Knowledge and Diffusion of Decision Functions. Most organizations

characterized by separation of decision management from residual risk bearing are

complex in the sense that specific knowledge relevant to different decisionsknowledge

which is costly to transfer across agentsis diffused among agents at all levels of the

organization. Again, we take it as given that the optimal organizations in some activities


are complex. Our theory attempts to explain the implications of complexity for the nature

of efficient decision processes and for control of agency problems in the decision process.

Since specific knowledge in complex organizations is diffused among agents,

diffusion of decision management can reduce costs by delegating the initiation and

implementation of decisions to the agents with valuable relevant knowledge. The agency

problems of diffuse decision management can then be reduced by separating the

management (initiation and implementation) and control (ratification and monitoring) of

decisions.

In the unusual cases where residual claims are not held by important decision

managers but are nevertheless concentrated in one or a few residual claimants, control of

decision managers can in principle be direct and simple, with the residual claimants

ratifying and monitoring important decisions and setting rewards.11 Such organizations

conform to our hypothesis, because top-level decision control is separated from top-level

decision managers and exercised directly by residual claimants.

However, in complex organizations valuable specific knowledge relevant to

decision control is diffused among many internal agents. This generally means that

efficient decision control, like efficient decision management, involves delegation and

diffusion of decision control as well as separation of decision management and control at

different levels of the organization. We expect to observe such delegation, diffusion, and

separation of decision management and control below the top level of complex

organizations, even in those unusual complex organizations where residual claims are

held primarily by top-level decision agents.

2. Diffuse Residual Claims and Delegation of Decision Control. In the more

common complex organizations, residual claims are diffused among many agents.

11 See Alchian and Demsetz (1972).


Having many residual claimants has advantages in large complex organizations because

the total risk of net cash flows to be shared is generally large and there are large demands

for wealth from residual claimants to bond the payoffs promised to a wide range of

agents and to purchase risky assets. When there are many residual claimants, it is costly

for all of them to be involved in decision control and it is efficient for them to delegate

decision control. For example, some delegation of decision control is observed even in

the large professional partnerships in public accounting and law, where the residual

claimants are expert internal decision agents. When there are many partners it is

inefficient for each to participate in ratification and monitoring of all decisions.

Nearly complete separation and specialization of decision control and residual

risk bearing is common in large open corporations and financial mutuals where most of

the diffuse residual claimants are not qualified for roles in the decision process and thus

delegate their decision control rights to other agents. When residual claimants have no

role in decision control, we expect to observe separation of the management and control

of important decisions at all levels of the organization.

Separation and diffusion of decision management and decision controlin effect,

the absence of a classical entrepreneurial decision makerlimit the power of individual

decision agents to expropriate the interests of residual claimants. The checks and

balances of such decision systems have costs, but they also have important benefits.

Diffusion and separation of decision management and control have benefits because they

allow valuable knowledge to be used at the points in the decision process where it is most

relevant and they help control the agency problems of diffuse residual claims. In complex

organizations, the benefits of diffuse residual claims and the benefits of separation of

decision functions from residual risk bearing are generally greater than the agency costs

they generate, including the costs of mechanisms to separate the management and control

of decisions.


3. Decision Control in Nonprofits and Financial Mutuals. Most organizations

characterized by separation of decision management from residual risk bearing are

complex. However, separation of the management and control of decisions contributes to

the survival of any organization where the important decision managers do not bear a

substantial share of the wealth effects of their decisionsthat is, any organization where

there are serious agency problems in the decision process. We argue below that

separation of decision management and residual risk bearing is a characteristic of

nonprofit organizations and financial mutuals, large and small, complex and noncomplex.

Thus, we expect to observe separation of the management and control of important

decisions even in small noncomplex nonprofits and financial mutuals where, ignoring

agency problems in the decision process, concentrated and combined decision

management and control would be more efficient.

4. Common General Features of Decision Control Systems. Our hypothesis

about the decision systems of organizations characterized by separation of decision

management and residual risk bearing gets support from the fact that the major

mechanisms for diffusing and separating the management and control of decisions are

much the same across different organizations.

Decision hierarchies. A common feature of the diffuse decision management

and control systems of complex organizations (for example, large nonprofit universities

as well as large open corporations) is a formal decision hierarchy with higher level agents

ratifying and monitoring the decision initiatives of lower level agents and evaluating their

performance.12 Such hierarchical partitioning of the decision process makes it more

difficult for decision agents at all levels of the organization to take actions that benefit

12 See Weber (1947); Blau (1956); Simon (1962); and the titles by Williamson (1975). The historical development of hierarchies in open corporations is analyzed in Chandler (1977); and Chandler and Daems (1980).


themselves at the expense of residual claimants. Decision hierarchies are buttressed by

organizational rules of the game, for example, accounting and budgeting systems, that

monitor and constrain the decision behavior of agents and specify the performance

criteria that determine rewards.13

Mutual monitoring systems. The formal hierarchies of complex organizations are

also buttressed by information from less formal mutual monitoring among agents. When

agents interact to produce outputs, they acquire low-cost information about colleagues,

information not directly available to higher level agents. Mutual monitoring systems tap

this information for use in the control process. Mutual monitoring systems derive their

energy from the interests of agents to use the internal agent markets of organizations to

enhance the value of human capital.14 Agents choose among organizations on the basis of

rewards offered and potential for development of human capital. Agents value the

competitive interaction that takes place within an organizations internal agent market

because it enhances current marginal products and contributes to human capital

development. Moreover, if agents perceive that evaluation of their performance is

unbiased (that is, if they cannot systematically fool their evaluators) then they value the

fine tuning of the reward system that results from mutual monitoring information,

because it lowers the uncertainty of payoffs from effort and skill. Since the incentive

structures and diffuse decision control systems that result from the interplay of formal

hierarchies and less formal mutual monitoring systems are also in the interests of residual

claimants, their survival value is evident.

13 The separation of decision management from decision control that we emphasize is reflected in the auditing professions concern with allocating operating and accounting responsibility to different agents. For instance, it is recommended that an agent with responsibility for billing should not have a role in receiving or recording customer payments. See, for example, Horngren (1982, ch. 27); or Stettler (1977, ch. 4 & 8).

14 See Fama (1980).


Boards of directors. The common apex of the decision control systems of

organizations, large and small, in which decision agents do not bear a major share of the

wealth effects of their decisions is some form of board of directors. Such boards always

have the power to hire, fire, and compensate the top-level decision managers and to ratify

and monitor important decisions. Exercise of these top-level decision control rights by a

group (the board) helps to ensure separation of decision management and control (that is,

the absence of an entrepreneurial decision maker) even at the top of the organization.15

IV. The Spectrum of Organizations

A. Introduction

Organizations in which important decision agents do not bear a major share of the

wealth effects of their decisions include open corporations, large professional

partnerships, financial mutuals, and nonprofits. We are concerned now with analyzing the

data each of these organizations provides to test the hypothesis that separation of decision

management functions from residual risk bearing leads to decision systems that separate

the management and control of decisions.

To motivate the discussion of specific organizational forms, we also outline a set

of more specialized propositions to explain the survival value of the special features of

their residual claims. These more specialized hypotheses about the survival of specific

organizational forms in specific activities are developed in our paper Agency Problems

and Residual Claims.16

15 Decision functions can be delegated in two general ways: (1) joint delegation to several agents (as in a committee), or (2) partitioning and delegation of the parts to different agents. Boards of directors are examples of the former approach; decision hierarchies are examples of the latter.

16 Fama and Jensen (1983).


B. Open Corporations

1. Unrestricted Common Stock Residual Claims. Most large nonfinancial

organizations are open corporations. The common stock residual claims of such

organizations are unrestricted in the sense that stockholders are not required to have any

other role in the organization, and their residual claims are freely alienable. As a result of

the unrestricted nature of the residual claims of open corporations, there is almost

complete specialization of decision management and residual risk bearing. Even

managers who own substantial blocs of stock, and thus are residual risk bearers, may

elect to sell these shares.

Unrestricted common stock is attractive in complicated risky activities where

substantial wealth provided by residual claimants is needed to bond the large aggregate

payoffs promised to many other agents. Unrestricted common stock, with its capacity for

generating large amounts of wealth from residual claimants on a permanent basis, is also

attractive in activities more efficiently carried out with large amounts of risky assets

owned within the organization rather than rented. Moreover, since decision skills are not

a necessary consequence of wealth or willingness to bear risk, the specialization of

decision management and residual risk bearing allowed by unrestricted common stock

enhances the adaptability of a complex organization to changes in the economic

environment. The unrestricted risk sharing and diversification allowed by common stock

also contributes to survival by lowering the cost of risk-bearing services.

2. Control of the Agency Problems of Common Stock. Separation and

specialization of decision management and residual risk bearing leads to agency

problems between decision agents and residual claimants. This is the problem of

separation of ownership and control that has long troubled students of corporations. For

example, potential exploitation of residual claimants by opportunistic decision agents is

reflected in the arguments leading to the establishment of the Securities and Exchange

Commission and in the concerns of the modern corporate governance movement. Less


well appreciated, however, is the fact that the unrestricted nature of common stock

residual claims also allows special market and organizational mechanisms for controlling

the agency problems of specialized risk bearing.

The stock market. The unrestricted alienability of the residual claims of open

corporations gives rise to an external monitoring device unique to these organizationsa

stock market that specializes in pricing common stocks and transferring them at low cost.

Stock prices are visible signals that summarize the implications of internal decisions for

current and future net cash flows. This external monitoring exerts pressure to orient a

corporations decision process toward the interests of residual claimants.

The market for takeovers. External monitoring from a takeover market is also

unique to the open corporation and is attributable to the unrestricted nature of its residual

claims.17 Because the residual claims are freely alienable and separable from roles in the

decision process, attacking managers can circumvent existing managers and the current

board to gain control of the decision process, either by a direct offer to purchase stock (a

tender offer) or by an appeal for stockholder votes for directors (a proxy fight).

Expert boards. Internal control in the open corporation is delegated by residual

claimants to a board of directors. Residual claimants generally retain approval rights (by

vote) on such matters as board membership, auditor choice, mergers, and new stock

issues. Other management and control functions are delegated by the residual claimants

to the board. The board then delegates most decision management functions and many

decision control functions to internal agents, but it retains ultimate control over internal

agentsincluding the rights to ratify and monitor major policy initiatives and to hire,

fire, and set the compensation of top level decision managers. Similar delegation of

decision management and control functions, at the first step to a board and then from the

17 Monitoring from the takeover market is emphasized in Manne (1965).


board to internal decision agents, is common to other organizations, such as financial

mutuals, nonprofits, and large professional partnerships, in which important decision

agents do not bear a major share of the wealth effects of their decisions.

However, the existence of the stock market and the market for takeovers, both

special to open corporations, explains some of the special features of corporate boards, in

particular: (1) why inside manager board members are generally more influential than

outside members, and (2) why outside board members are often decision agents in other

complex organizations.18

Since the takeover market provides an external court of last resort for protection

of residual claimants, a corporate board can be in the hands of agents who are decision

experts. Given that the board is to be composed of experts, it is natural that its most

influential members are internal managers since they have valuable specific information

about the organizations activities. It is also natural that when the internal decision

control system works well, the outside members of the board are nominated by internal

managers. Internal managers can use their knowledge of the organization to nominate

outside board members with relevant complementary knowledge: for example, outsiders

with expertise in capital markets, corporate law, or relevant technology who provide an

important support function to the top managers in dealing with specialized decision

problems.

However, the board is not an effective device for decision control unless it limits

the decision discretion of individual top managers. The board is the top-level court of

appeals of the internal agent market,19 and as such it must be able to use information from

the internal mutual monitoring system. To accomplish this and to achieve effective

18 See Herman (1981, ch. 2), for data on the characteristics of corporate boards.

19 See Fama (1980).


separation of top-level decision management and control, we expect the board of a large

open corporation to include several of the organizations top managers. The board uses

information from each of the top managers about his decision initiatives and the decision

initiatives and performance of other managers. The board also seeks information from

lower level managers about the decision initiatives and performance of top managers.20

This information is used to set the rewards of the top managers, to rank them, and to

choose among their decision initiatives. To protect information flows to the board, we

expect that top managers, especially those who are members of the board, can effectively

be fired only with consent of the board and thus are protected from reprisals from other

top managers.

The decision processes of some open corporations seem to be dominated by an

individual manager, generally the chief executive officer. In some cases, this signals the

absence of separation of decision management and decision control, and, in our theory,

the organization suffers in the competition for survival. We expect, however, that the

apparent dominance of some top managers is more often due to their ability to work with

the decision control systems of their organizations than to their ability to suppress diffuse

and separate decision control. In any case, the financial press regularly reports instances

where apparently dominant executives are removed by their boards.

Corporate boards generally include outside members, that is, members who are

not internal managers, and they often hold a majority of seats.21 The outside board

members act as arbiters in disagreements among internal managers and carry out tasks

20 For example, Horngren (1982, at 911), describes the role of the audit committee of the board (generally composed of outside board members) as a collector and conduit of information from the internal mutual monitoring system: The objective of the audit committee is to oversee the accounting controls, financial statements, and financial affairs of the corporation. The committee represents the full board and provides personal contact and communication among the board, the external auditors, the internal auditors, the financial executives, and the operating executives.

21 See Herman (1981, ch. 2).


that involve serious agency problems between internal managers and residual claimants,

for example, setting executive compensation or searching for replacements for top

managers.

Effective separation of top-level decision management and control means that

outside directors have incentives to carry out their tasks and do not collude with

managers to expropriate residual claimants. Our hypothesis is that outside directors have

incentives to develop reputations as experts in decision control. Most outside directors of

open corporations are either managers of other corporations or important decision agents

in other complex organizations.22 The value of their human capital depends primarily on

their performance as internal decision managers in other organizations. They use their

directorships to signal to internal and external markets for decision agents that (1) they

are decision experts, (2) they understand the importance of diffuse and separate decision

control, and (3) they can work with such decision control systems. The signals are

credible when the direct payments to outside directors are small, but there is substantial

devaluation of human capital when internal decision control breaks down and the costly

last resort process of an outside takeover is activated.

C. Professional Partnerships

1. Mutual Monitoring, Specific Knowledge, and Restricted Residual Claims.

The residual claims of professional partnerships in activities such as law, public

accounting, medicine, and business consulting are restricted to the major professional

agents who produce the organizations services. This restriction increases the incentives

of agents to monitor each others actions and to consult with each other to improve the

quality of services provided to customers. Such mutual monitoring and consulting are

attractive to the professional agents in service activities where responsibility for variation

22 See Herman (1981, ch. 2).


in the quality of services is easily assigned and the value of professional human capital is

sensitive to performance. The monitoring and consulting are likely to be effective when

professional agents with similar specialized skills agree to share liability for the actions

of colleagues.

In both large and small partnerships, individuals or small teams work on cases,

audits, and so forth. Because of the importance of specific knowledge about particular

clients and circumstances, it is efficient for the teams to make most decisions locally. At

this level. however, decision management and decision control are not separate. To

control the resulting agency problems, the residual claims in professional partnerships,

large and small, are restricted to the professional agents who have the major decision-

making roles. This is consistent with our hypothesis that combination of decision

management and control functions leads to restriction of residual claims to the agents

who both manage and control important decisions.

2. Large Professional Partnerships. The partners in large professional

partnerships are diffuse residual claimants whose welfare depends on the acts of agents

they do not directly control. Thus, these organizations provide a test of our hypothesis

that separation of residual risk bearing and decision management induces decision

systems that separate the management and control of important decisions. The major

decision control devices of large professional partnerships are similar to those of other

organizations with diffuse residual claims. For example, residual claimants in large

partnerships delegate to boards the ratification and monitoring of important decisions

above the level of individual cases and audits. Moreover, the sharing of liability and

residual cash flows among important decision agents (the partners) ensures that large

partnerships have strong versions of the mutual monitoring systems that we contend are

common to the decision control systems of complex organizations.

The boards of large partnerships have special features that relate to the restriction

of the residual claims to important internal agents. The residual claimants are experts in


the organizations activities, and they observe directly the effects of actions taken by the

board of managing partners. Thus, unlike the stockholders of open corporations, the

residual claimants in large partnerships have little demand for outside experts to protect

their interests, and their boards are composed entirely of partners.

The board is involved in decisions with respect to the management of the

partnership, for example, where new offices should be opened, who should be admitted to

the partnership, and who should be dismissed. The board is also involved in renegotiating

the shares of the partners. Here, as in other decisions, the boards of large partnerships

combine the valuable specific knowledge available at the top level with information from

partner-residual claimants. The role of the board is to develop acceptable consensus

decisions from this information. Thus, the boards of large professional partnerships are

generally called committees of managing partners rather than boards of directors. The

idea is that such committees exist to manage agency problems among partners and to

study and determine major policy issues in a manner that is less costly than when

performed jointly by all partners.

Since the residual claims in a large professional partnership are not alienable,

unfriendly outside takeovers are not possible. Inside takeovers by dissident partners are

possible, however, because the managing boards of these organizations are elected by the

partner-residual claimants.

D. Financial Mutuals

A common form of organization in financial activities is the mutual. An unusual

characteristic of mutuals is that the residual claimants are customers, for example, the

policyholders of mutual insurance companies, the depositors of mutual savings banks,

and the shareholders of mutual funds. Like the diffuse stockholders of large nonfinancial

corporations, most of the diffuse depositors, policyholders, and mutual fund shareholders

of financial mutuals do not participate in the internal decision process. Thus, financial


mutuals provide another test of our hypothesis that substantial separation of decision

management and residual risk bearing leads to decision systems that separate the

management and control of decisions.

1. The Control Function of Redeemable Claims. For the purpose of decision

control, the unique characteristic of the residual claims of mutuals is that they are

redeemable on demand. The policyholder, depositor, or shareholder can, on demand, turn

in his claim at a price determined by a prespecified rule. For example, the shareholder of

an open-end mutual fund can redeem his claim for the market value of his share of the

funds assets, while the whole life or endowment insurance policyholder, like the

shareholder of a mutual savings bank, can redeem his claim for its specified value plus

accumulated dividends.

The decision of the claim holder to withdraw resources is a form of partial

takeover or liquidation which deprives management of control over assets. This control

right can be exercised independently by each claim holder. It does not require a proxy

fight, a tender offer, or any other concerted takeover bid. In contrast, customer decisions

in open nonfinancial corporations and the repricing of the corporations securities in the

capital market provide signals about the performance of its decision agents. Without

further action, however, either internal or from the market for takeovers, the judgments of

customers and of the capital market leave the assets of the open nonfinancial corporation

under the control of the managers.

2. The Board of Directors. Like other organizations characterized by substantial

separation between decision management and residual risk bearing, the top-level decision

control device in financial mutuals is a board of directors. Because of the strong form of

diffuse decision control inherent in the redeemable residual claims of financial mutuals,

however, their boards are less important in the control process than the boards of open

nonfinancial corporations. The reduced role of the board is especially evident in mutual

savings banks and mutual funds, which are not complex even though often large in terms


of assets. Moreover, the residual claimants of mutuals show little interest in their boards

and often do not have the right to vote for board members.23 Outside board members are

generally chosen by internal managers. Unlike open corporations, the boards of financial

mutuals do not often impose changes in managers. The role of the board, especially in the

less complex mutuals, is largely limited to monitoring agency problems against which

redemption of residual claims offers little protection, for example, fraud or outright theft

of assets by internal agents.

E. Nonprofit Organizations

When an organizations activities are financed in part through donations, part of

net cash flows is from resources provided by donors. Contracts that define the share of

residual claimants in net cash flows are unlikely to assure donors that their resources are

protected from expropriation by residual claimants. In a nonprofit organization, however,

there are no agents with alienable rights in residual net cash flows and thus there are no

residual claims. We argue in Agency Problems and Residual Claims that the absence

of such residual claims in nonprofits avoids the donor-residual claimant agency problem

and explains the dominance of nonprofits in donor-financed activities.24

The absence of residual claims in nonprofits avoids agency problems between

donors and residual claimants, but the incentives of other internal agents to expropriate

donations remain. These agency problems between donors and decision agents in

nonprofits are similar to those in other organizations where important decision managers

do not bear a major share of the wealth effects of their decisions. Our hypothesis predicts

that, like other organizations characterized by separation of decision management from

23 See Herman (1969), for documentation of such lack of interest. For example, he describes situations where in more than a decade only four depositors in total attended the annual meetings of two savings and loan associations and other situations where management did not even bother to collect proxies.

24 Fama and Jensen (1983). See Hansmann (1980) for a general discussion of nonprofits.


residual risk bearing, nonprofits have decision systems that separate the management

(initiation and implementation) and control (ratification and monitoring) of decisions.

Such decision systems survive in donor nonprofits because of the assurances they provide

that donations are used effectively and are not easily expropriated.

1. Nonprofit Boards. In small nonprofits delegation of decision management to

one or a few agents is generally efficient. For example, in nonprofit cultural performing

groups, an artistic director usually chooses performers, does the primary monitoring of

their outputs, and initiates and implements major decisions. Nevertheless, the important

decision agents in these organizations are chosen, monitored, and evaluated by boards of

directors. Boards with similar decision control rights are common to other small

nonprofits characterized by concentrated decision management, such as charities, private

museums, small private hospitals, and local Protestant and Jewish congregations. Boards

are also observed at the top of the decision control systems of complex nonprofits, such

as private universities, in which both decision management and decision control are

diffuse.

Although their functions are similar to those of other organizations, nonprofit

boards have special features that are due to the absence of alienable residual claims. For

example, because of the discipline from the outside takeover market, boards of open

corporations can include internal decision agents, and outside board members can be

chosen for expertise rather than because they are important residual claimants. In

contrast, because a nonprofit lacks alienable residual claims, the decision agents are

immune from ouster (via takeover) by outside agents. Without the takeover threat or the

discipline imposed by residual claimants with the right to remove members of the board,

nonprofit boards composed of internal agents and outside experts chosen by internal

agents would provide little assurance against collusion and expropriation of donations.

Thus, nonprofit boards generally include few if any internal agents as voting members,

and nonprofit boards are often self-perpetuating, that is, new members are approved by


existing members. Moreover, nonprofit board members are generally substantial donors

who serve without pay. Willingness to provide continuing personal donations of wealth

or time is generally an implicit condition for membership on nonprofit boards.

Acceptance of this condition certifies to other donors that board members are motivated

to take their decision control task seriously.

2. The Roman Catholic Church. To our knowledge the only nonprofit

organization that is financed with donations but lacks a board of important continuing

donors with effective decision control rights is the Roman Catholic church. Parish

councils exist in local Catholic churches, but unlike their Protestant and Jewish

counterparts, they are only advisory. The clerical hierarchy controls the allocation of

resources, and the papal system does not seem to limit the discretion of the Pope, the

organizations most important decision agent.

Other aspects of the contracts of the Catholic clergy in part substitute for the

control of expropriation of donations that would be provided by more effective donor-

customer constraints on decisions. For example, the vows of chastity and obedience

incorporated into the contracts of the Catholic clergy help to bond against expropriation

of donations by avoiding conflicts between the material interests of a family and the

interests of donor-customers. In addition, the training of a Catholic priest is organization-

specific. For example, it involves a heavy concentration on (Catholic) theology, whereas

the training of Protestant ministers places more emphasis on social service skills. Once

certified, the Catholic priest is placed by the hierarchy. He cannot offer his services on a

competitive basis. In exchange for developing such organization-specific human capital,

the Catholic priest, unlike his Protestant and Jewish counterparts, gets a lifetime contract

that promises a real standard of living. The organization-specific nature of the human

capital of the Catholic clergy and the terms of the contract under which it is employed act

as a bond to donor-customers that the interests of the Catholic clergy are closely bound to

the survival of the organization and thus to the interests of donor-customers.


Although Protestantism arose over doctrinal issues, the control structures of

Protestant sectsin particular, the evolution of lay councils with power to ratify and

monitor resource allocation decisionscan be viewed as a response to breakdowns of the

contract structure of Catholicism, that is, expropriation of Catholic donor-customers by

the clergy. The evolution of Protestantism is therefore an example of competition among

alternative contract structures to resolve an activitys major agency problemin this case

monitoring important agents to limit expropriation of donations.

There is currently pressure to allow Catholic priests to marry, that is, to drop the

vow of chastity from their contracts. We predict that if this occurs, organizational

survival will require other monitoring and bonding mechanisms, for example, control

over allocation of resources by lay councils similar to those observed in Protestant and

Jewish congregations.

3. The Private University and Decision Systems in Complex Nonprofits. In

complex nonprofits we observe mechanisms for diffuse decision control similar to those

of other complex organizations. For example, large private universities, like large open

corporations, have complicated decision hierarchies and active internal agent markets

with mutual monitoring systems that generate information about the performance of

agents. Again, however, the decision control structures of complex nonprofits have

special features attributable to the absence of alienable residual claims.

For example, a universitys trustees are primarily donors rather than experts in the

details of education or research. In ratifying and monitoring decision initiatives presented

by internal decision agents (presidents, chancellors, provosts, etc.), and in evaluating the

agents themselves, boards rely on information from the internal diffuse decision

systemfor example, reports from faculty senates and appointments committeesand

on external peer reviews.

Moreover, the structure of internal diffuse decision control systems is a more

formal part of a universitys contract structure (its charter or by-laws) than in large for-


profit organizations such as open corporations. For example, unlike corporate managers.

university deans, department heads, provosts, and presidents are generally appointed for

fixed terms. The end of a contract period activates a process of evaluation, with search

committees chosen according to formal rules and with rules for passing their

recommendations on to the board. A more formal structure of diffuse decision

management and control is helpful to trustees who do not have specialized knowledge

about a universitys activities. It also helps to assure donors that the absence of discipline

from an outside takeover market is compensated by a strong system for internal decision

control.

V. Summary

The theory developed in this paper views an organization as a nexus of contracts

(written and unwritten). The theory focuses on the contracts that (1) allocate the steps in

an organizations decision process, (2) define residual claims, and (3) set up devices for

controlling agency problems in the decision process. We focus on the factors that give

survival value to organizational forms that separate what the literature imprecisely calls

ownership and control.

A. The Central Hypotheses

An organizations decision process consists of decision management (initiation

and implementation) and decision control (ratification and monitoring). Our analysis

produces two complementary hypotheses about the relations between decision systems

and residual claims:

Separation of residual risk bearing from decision management leads to decision

systems that separate decision management from decision control.

Combination of decision management and decision control in a few agents leads

to residual claims that are largely restricted to these agents.


B. Combination of Decision Management and Control

When it is efficient to combine decision management and control functions in one

or a few agents, it is efficient to control agency problems between residual claimants and

decision makers by restricting residual claims to the decision makers. This proposition

gets clear support from the proprietorships, small partnerships, and closed corporations

observed in small-scale production and service activities. These organizations are all

characterized by concentrated decision systems and residual claims that are restricted to

decision agents.

C. Separation of Residual Risk Bearing from Decision Management

1. The Role of Specific Knowledge. In contrast, most of the organizations

characterized by separation of residual risk bearing from decision management are

complex in the sense that specific information valuable for decisions is diffused among

many agents throughout the organization. Thus in a complex organization separation of

residual risk bearing from decision management arises in part because efficient decision

systems are diffuse. Benefits from better decisions can be achieved by delegating

decision functions to agents at all levels of the organization who have relevant specific

knowledge, rather than allocating all decision management and control to the residual

claimants. Control of the agency problems of such diffuse decision systems is then

achieved by separating the ratification and monitoring of decisions (decision control)

from initiation and implementation (decision management). The efficiency of such

decision systems is buttressed by incentive structures that reward agents both for

initiating and implementing decisions and for ratifying and monitoring the decision

management of other agents.

2. The Role of Diffuse Residual Claims. In most complex organizations,

residual claims are diffused among many agents. When there are many residual

claimants, it is costly for all of them to be involved in decision control. As a consequence


there is separation of residual risk bearing from decision control, and this creates agency

problems between residual claimants and decision agents. Separation of decision

management and decision control at all levels of the organization helps to control these

agency problems by limiting the power of individual agents to expropriate the interests of

residual claimants. Thus diffusion and separation of decision management and control

have survival value in complex organizations both because they allow valuable specific

knowledge to be used at the points in the decision process where it is most relevant and

because they help control the agency problems of diffuse residual claims.

3. Common Features of Decision Control Systems. What we call separation of

residual risk bearing from decision management is the separation of ownership and

control that has long bothered students of open corporations. We argue that separation of

decision and risk bearing functions is also common to other organizations like large

professional partnerships, financial mutuals, and nonprofits. Moreover, our central

hypothesis about control of the agency problems caused by separation of residual risk

bearing from decision management gets support from the fact that the major mechanisms

for separating decision management and decision control are much the same across

organizations.

The common central building blocks of the diffuse decision control systems of

complex organizations of all types are formal decision hierarchies in which the decision

initiatives of lower level agents are passed on to higher level agents, first for ratification

and then for monitoring. Such decision hierarchies are found in large open corporations,

large professional partnerships, large financial mutuals, and large nonprofits. Formal

decision hierarchies are buttressed by less formal mutual monitoring systems that are a

by-product of interaction that takes place to produce outputs and develop human capital.

The common apex of the decision control systems of organizations, large and

small, in which decision agents do not bear a major share of the wealth effects of their

decisions is a board of directors (trustees, managing partners, etc.) that ratifies and


monitors important decisions and chooses, dismisses, and rewards important decision

agents. Such multiple-member boards make collusion between top-level decision

management and control agents more difficult, and they are the mechanism that allows

separation of the management and control of the organizations most important decisions.

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